Shock Therapy

Encyclopedia of Russian History
COPYRIGHT 2004 The Gale Group Inc.

SHOCK THERAPY

The term shock therapy has come to arouse a great deal of controversy. Its original use was related to the use of electrical shocks as therapy in psychiatric treatment. In economic policy, it has been used to describe powerful austerity measures designed to break spirals of very rapid inflation. More recently, it has been used as a blanket term for policies designed to reform the postsocialist economies of Eastern Europe and the former Soviet Union. The latter also is where the main controversies have arisen.

The divergence of opinion concerning reform policy can be attributed in large part to the disparate nature of the tasks involved. Setting out to break inflation is different from seeking to under-take a broad socioeconomic transformation from failed centrally planned economies into functioning market economies. Above all, the political implications are very different.

In a first stage, beginning after the fall of the Berlin Wall in 1989, postsocialist governments in Central Europe embarked on economic reform programs that featured rapid liberalization and broad-based privatization. It has been held by some that those who succeeded did so because they applied shock therapy. Others, notably so people from the region, have rejected such claims, arguing that foreign advice had little to do with their achievements.

The main test of shock therapy came in the first half of 1992, when the Russian government of Yegor Gaidar sought to implement rapid and radical systemic change. The bulk of all prices were liberalized and state owned enterprises were informed that their life support systems, in the form of direct financial links to the state budget, would be terminated.

It was believed that this "shock" to the system also would bring a form of therapy in its wake. As enterprise managers realized that they could no longer count on automatic subsidies from the state budget, they would be forced into producing goods that could be sold on real markets, at prices that would cover their costs. It was expected that within a period of one-half of one year or so the transition should be completed. From there on the Russian economy would be growing at a healthy pace, and no more foreign economic support would be needed.

By the summer of 1992 it became painfully evident that the project was failing. Enterprises had responded to the government's austerity measures not by cultivating markets, but by developing a subsequently chronic practice of non-payments. Losses of government subsidies were met by reduced payments on due taxes and wages. Failures to receive payments from customers were met by refusals to pay suppliers. Reduced government orders were met by reductions in output, but could not result in closures since there was no bankruptcy law.

It was also clear that the associated ambitions of bringing stability to government finance had met with equal disaster. Inflation was spiraling out of control, ending up at well more than 2,000 percent for the year as a whole, and persistent deficits in the state budget would come to haunt the government for several years to come.

Ten years later the evidence remains fairly bleak. Between 1991 and 1998, the Russian economy lost around 40 percent of GDP and more than 80 percent of capital investment. There was mass impoverishment of the population, serious decay of the country's infrastructure, and a general widening of the technology gap against the industrialized world. In August 1998, a brewing financial crisis produced a massive crash, leaving investors with tens of billions of dollars in losses.

In the policy debates that surrounded the initial failures of rapid systemic change, two different sides emerged. One side, representing many market analysts, argued that the reason behind the initial failures was linked to insufficient shock. In their view, the crash of 1998 actually was a good thing, laying the groundwork for the economic upturn in 2000 and 2001.

The other side, representing mainly non-economists and a minority of uninvolved academic economists, held that the policy of shock therapy as such has been at fault, and that a set of alternative policies would have allowed much of the destruction to be avoided. Today it would seem fair to say that the latter represents the majority view.

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